Investors Ante Up and Drive Late-Week Rally

MOST CLOSE OBSERVERS seem to agree that the stock market is coiled in anticipation of its next move. But they're arguing about whether the market is more like a compressed spring prepared to bounce higher or a Slinky poised to head downstairs.

Last week dealt investors enough conflicting signals to keep both sides entrenched in their positions. After four weeks spent churning steadily lower, the selling pressure abated and stocks swept higher to finish out the week slightly higher.

The Dow Jones Industrial Average rose 158 points Friday, helping the index to a slim 44-point gain on the week by the time it closed at 7908. The Standard & Poor's 500 index eked out a 5-point advance to settle at 834. The Nasdaq Composite, helped by an impressive profit report from
Dell Computer
late Thursday, again outperformed the broader market by adding 27 points, or 2.1%, to finish at 1310.

Trading volume was moderate and the rebound in the markets, which reversed only about a week's worth of losses, didn't seem to be inspired by any particular news. Friday's rally was staged almost entirely after U.N. weapons inspection chief Hans Blix completed his inconclusive report on Iraq, leaving the impression that the diplomatic impasse wasn't likely to change suddenly over the long holiday weekend.

All trading these days, however, takes place in the context of a broad perception that the market could very well take off to the upside if a speedy military victory over Iraq happens with a hoped-for rally that no one wants to miss.

The sharpest line between bulls and bears right now centers on what each group insists "everyone" is thinking. The bulls will tell you "everyone's bearish, the smart play is to buy," while skeptics are convinced that "everyone is playing for a post-war rally, so there probably won't be one." A lot of poker is being played, with traders less concerned with the quality of their own hand than with figuring out who's bluffing.

Technical patterns have become constant fixations among Wall Street professionals, with plenty of them last week swooping in to buy when the S&P 500 held firm near 820 and the VIX gauge of investor anxiety passed the 40 mark. Even with those signals appearing, though, the "oversold" condition of the market never quite reached levels of last October or July, the staging areas for the last two cyclical rallies.

It might be granting investors too much of a taste for detail to say that actual fundamental data presaged the market's turn higher, but some economic figures have, in fact, offered evidence that the economy is firming. Last week, January retail sales (excluding automobiles) rose more than expected, industrial production strengthened nicely and weekly unemployment claims fell for a second consecutive week.

None of that suggests the kind of economic acceleration that will probably be needed to drive corporate profits toward current forecasted levels, but the data offer hopeful signs that the U.S. economy is not in paralysis over the prospect of a war, even if much of Wall Street is.

There was an unlikely harmony in various market indexes Wednesday, when the S&P 500, the Nasdaq Composite and the Russell 2000 were all down by exactly the same amount, 1.27%. Then Thursday, when midday losses were nearly wiped out by a sudden and hard-to-figure rally, those three and the Dow all finished lower by 0.11% to 0.17% -- essentially, a dead heat.

This unanimity isn't just a statistical curiosity. It speaks to the way the market is trading almost as a single instrument lately, swayed by global concerns and traders' emotions that play out in the index futures market, then sway stock prices. In these times, corporate news often fails to influence individual security prices, and Wall Street, in violation of a hoary adage, becomes not so much "a market of stocks" but a monolithic asset class.

Robin Carpenter of Carpenter Analytix in Hanover, N.H., not only notes this phenomenon, but also puts a number on it. He studies the "dispersion" level of the market, meaning the degree to which stocks are acting independently or with a high degree of "sameness." The level Wednesday was in the lowest 4% of all readings since before the 1998 financial crisis, meaning stocks were acting very similarly, and it remained unusually low all week.

This is especially unusual at a time of market weakness, Carpenter says. Typically, dispersion rises as the indexes fall, just as statistical readings of market volatility do. Carpenter indicates that a lack of stock-versus-stock volatility indicates a complacency that tends to be associated with subsequent price declines, according to the historical record.

"Being so low in face of recent decline is remarkable, and I believe a sign of continuing weakness," he says.

Market theorists insist that all relevant available information -- whether in financial footnotes or scrawled on the walls of subway tunnels -- is efficiently priced into stocks by the collective efforts of the free market. Daily inhabitants of trading desks understand that investors can willfully ignore important information when they can get away with it.

These opposing notions will be tested this year as new rules governing the exclusion of certain items from what companies call "pro forma" or "operating" earnings take effect. These new procedures will require companies to present their results with prominent reference to earnings under those rigid generally accepted accounting principles, and will force detailed explanations for all so-called "extraordinary" items. The rules, part of the Sarbanes-Oxley Act on corporate governance, will in effect make it harder for companies to cast their performance in the favorable light of their own choosing.

There has always been some variance between GAAP earnings and the operating results that companies report exclusive of one-time charges, asset sales and the like. But in the last couple of years, GAAP earnings have veered sharply away from the by-the-book calculations of corporate performance.

David Bianco of UBS Warburg reports in a new and thorough study of the issue that from 1991 through 2000 GAAP earnings accounted for 84% of operating earnings. Put another way, one-sixth of companies' bottom lines came from things that GAAP does not deem "real" earnings. Then came the writeoff derby and profit recession of 2001-2002, when only a little more than half of operating earnings -- the kind that analysts try to forecast -- counted as GAAP earnings.

Only eight S&P 500 companies reported "pro forma" earnings that equaled GAAP earnings for each of the last 12 quarters, and 85 of the companies never once had the earnings measures they emphasized in their press releases conform to GAAP.

The new rules "will unmask a lower level of normalized earnings," says Bianco, as companies "use [special] charges far less frequently and take smaller ones."

The coming rules and the related effects on corporate reporting practices could shave as much as 10% off the published earnings forecasts for S&P 500 companies, Bianco figures. Going a step further, Bianco estimates that "poor quality earnings" in the form of unearned pension income, employee-stock option costs and off-balance sheet transactions might make up $10 of the expected $52 per share in S&P 500 earnings projected for 2003.

If, indeed, true earnings for this year are closer to $42 than $52, it balloons the effective forward price/earnings multiple of the market to almost 20, rather than the more palatable 15 that's based on projected operating earnings. That would mean the market remains quite expensive in historical terms, even after three years of stock declines.

Those in the efficient-market sect will say that simply changing the way certain financial items are classified won't matter to investors. But those pragmatists with a healthy faith in humans' capacity for self-delusion will be betting that the less-flattering reporting procedures will cause an adverse reaction from the investment community.

Bianco falls into the latter camp. He writes: "We are not comfortable with arguments that discount the possibility of share price corrections if pro forma earnings decline to levels more in-line with GAAP." As for those who say the stock market has already built in a lower stated earnings base, he says, "We think it is partial at best."

Charles Schwab
has been aggressively opportunistic in seizing on the mass disillusionment with Wall Street research, mocking full-service brokers in television commercials and sanctimoniously professing its own investment advice to be unbiased.

This position obscures a couple of facts. The first is that Schwab's selling proposition isn't discernibly winning it business from other brokers. The second is that biased research can come in many forms and isn't limited to analysts favoring potential investment-banking clients.

Last week, Schwab reported its customers' average daily trading volume had fallen 23% in January from the level a year earlier and was 3% below December's average, bringing the pace of Schwab clients' activity back to late 1998 levels. The firm said that, unless things pick up, it won't meet first-quarter earnings expectations of eight cents a share. Schwab did pull in $4 billion in net new assets last month, about the same rate of inflow as last year, but that doesn't suggest big market-share gains. Schwab shares are down 24% from 10.85 already this year, yet still don't appear inexpensive, based on plausible earnings power.

The company's research generally takes the form of quantitative stock ratings and mutual-fund picks. But it also cultivates an image of a detached think tank with its Schwab Center for Investment Research, which produces studies on the markets and investing techniques. Last week, this arm of the firm released a piece of research intended to show that attempting to find the "best time" to enter the market isn't worthwhile and that the most prudent tack is always to put money into stocks at the earliest possible moment.

The study tested the hypothetical results of several approaches. These included simply investing available cash every Jan. 1; dollar-cost averaging through monthly investments; "perfect timing" in which stocks were magically bought at a given year's lowest monthly close; bad timing, or investing at the year's high; and simply never investing in stocks.

The results showed -- no surprise -- that the purely fantastical perfect timing method generated the greatest return over 20 years, but was only slightly more lucrative than mechanically putting money to work as soon as possible. The rest of the methods fell short by a wider margin, and the worst return came from staying out of stocks and in Treasury bills.

It might be enough evidence to get a reader to write a check directly to Schwab's stock-index funds. Except that this analysis was performed only for the years 1983 through 2002. That period, of course, was dominated by the greatest bull market of all time, which in the view of some analysts lasted uninterrupted for 18 years beginning in late 1982. During that period those hypothetical annual investments would have compounded at astounding rates and as never before. Sure, the period also covers almost two years of the current nasty bear assault, but even that hasn't much dented stocks' glorious tenfold increase since '82.

The data aren't wrong, of course, just so specific to an unprecedented period of market appreciation as to be essentially irrelevant for another environment. Such as the current one, when many experts believe 1970s-type, cyclical market moves within a broad trading range are likely for years to come. Schwab's research doesn't much help investors on that score.

It just goes to show that the securities industry's marketing machinery has survived three years of a bear market. And whether a full-service firm or discount broker is doing the talking, the pitch still tends to be biased toward one conclusion: "Send us your money now."

An asset mix of 50% equities, 45% fixed-income instruments and 5% commodities and foreign exchange might hold some appeal these days, as balanced portfolios return to popularity. That, very roughly speaking, is what you get by owning shares in the
Chicago Mercantile Exchange,
whose business of making markets in derivatives breaks down in those proportions.

The CME went public in December, the first major U.S. securities exchange to do so, and the stock has performed well, rising to around 44 from its IPO price of $35. The shares function as a pure play on derivatives trading, market volatility and the desire among investors to hedge market risk. All three of those things show only signs of increasing.

Most of the exchange's business comes from trading -- both on its floor and electronically -- of Eurodollar interest-rate futures and stock-index futures, most notably S&P index products. Commodities include pork bellies and other meat futures. The company last week declared its first quarterly dividend, of 14 cents a share, and management has said it plans to pay 20% of each year's earnings in dividends.

The CME's earnings are running at a rate of a bit more than $3 a share, placing its price/earnings multiple of expected 2003 profit just above 14. That isn't terribly cheap for a capital-markets related company, but the CME is unique in several respects. It has almost no debt, isn't very capital intensive and has a return on equity above 30% -- more than double what most securities firms can achieve in today's tough markets.

The CME makes money from trading volumes rather than market direction, and volumes have remained strong. It owns its own trade-clearing division, which is a fee-based business with minimal credit or market risk. According to UBS Warburg (one of the IPO underwriters), the CME has a lower valuation based on cash flow than the average publicly traded European futures exchange.

While the stock would be more fairly valued around 50, according to those analysts who have begun following it, the shares could come under pressure in coming months as insiders are allowed to sell. Only 15% of the outstanding shares are in public hands, leading to some volatility in the stock. Insiders, including CME members who got stock when the company converted from a mutually owned structure, will be able to sell seven million shares in June, and another 20 million over the next year and a half.

If the stock suffers as the lock-up expiration approaches, it could offer an even more attractive opportunity to buy a piece of one of the market's better middlemen.

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